Financial Planning 101 - What you need to know about 401k plans
Probably the most popular type of investment account in the United States today is the 401k account. According to a 2019 document from the American Benefits Council there are 100 million 401k accounts in the United States holding over $6 trillion. That is almost one account for every two people over the age of 18.
What exactly is a 401k account? It is an employer sponsored retirement account that allows you to contribute pre-tax dollars into an investment account. In many cases the employer will contribute funds into the account as well. The funds in the account will continue to grow tax deferred until the funds are withdrawn. At the time of withdrawl the funds are treated as taxable income. Most people are aware of these basic facts so let’s dig a little more into the details of the plan.
As stated above, the employee makes pre-tax contributions into the account. The annual limit for contributions an employee can make in a year is $19,500. If you are age 50 or older you can make catch up contributions up to an additional $6,500 for a total of $26,000. In most 401k plans you can choose to make these contributions as either a percentage of your income or a flat dollar amount.
What does pre-tax mean?
Pre-tax contributions means that the income you direct into the 401k plan avoids income tax. For example, if you have a salary of $50,000 and you contribute 10%, or $5000, your state and federal income tax is based on the remaining $45,000 of salary. Income used for 401k contributions are still subject to Social Security and Medicare taxes though.
Tax deferred growth
Different types of investment accounts have different tax treatments. The 401k, as we’ve mentioned is funded with pre-tax income. The other key tax treatment is tax deferred growth. This means that during the time assets are accumulating in the account that individual assets within the account can be bought and sold and there is no tax on the gains realized for any of those transactions. There is no tax due at all until funds are withdrawn.
While the whole tax deferral and pre-tax contribution things are great, the employer match is the truly powerful component of the 401k plan. Depending upon how the plan is structured the employer typically will contribute a certain percentage of your income to the plan depending upon how much you contribute. Typical plans will have rules such as the employer contributing .5% for every 1% you contribute up to 6% or a dollar for dollar match on the first 4% or something to that effect. That is a 50 or 100% immediate return on the amounts you are putting into the plan. That is the best return you will find and contributing at least to the point where you get the full match is considered one of the bigger no brainers in personal finance. Each plan may have slightly different matching rules so refer to your Summary Plan Description (SPD) to get the details on your plan.
Vesting is the concept of obtaining rights to the funds within a 401k over time. Funds that you contribute from your paycheck into the plan are 100% vested immediately as that is your money. Matching funds contributed from the employer are a different story though. Many plans will have a defined schedule, for example 25% each year so that after four years you are fully vested. Again, look to your SPD for the specifics on your plan’s vesting information.
Since the 401k is a retirement account there are rules around when and how you can take money out. Withdrawls can begin at age 59 ½ penalty free (there are a few exceptions where you can take penalty free withdrawls earlier). Remember the funds in these accounts have never been taxed so the entire amount you withdraw is considered taxable income for federal and state income tax purposes.
And while most of us are aware about the penalty for early withdrawls there is also a provision on the backend dictating when you have to start taking money out of the 401k. Why? Again, the government has never received tax revenue from any of the money in this account and they want to begin getting their share. This concept is known as Required Minimum Distribution (RMD). At the age of 72 you have to begin taking withdrawls from the account based on an IRS life expectancy table.
If you are over age 59 ½ you can begin withdrawing funds from a 401k plan penalty free from a previous employers plan. You will have to refer to your SPD about making withdrawls from your current employers plan if over age 59 ½.
A typical 401k plan has a limited number of investment options but most will include a fund choice from each of the following categories: domestic stock fund, international stock fund, bond fund, money market fund and target date options. This will allow you to build a basic diversified portfolio at a minimum. Many funds are now setup to automatically enroll people in the appropriate target date fund as a default option.
Many people don’t consider the costs involved in a 401k plan but they do exist. Each fund that you invest in within the 401k plan has what’s called an expense ratio. This is shown as a percentage and that percentage is charged based on the amount you have invested in that particular fund. These fees can range from 2% to almost zero. Be aware of funds with high fees. Anything over 1% can be deemed high given the amount of low cost funds that are available.
The second cost is the one paid to the company who is managing the 401k plan on behalf of the employer. This should be a very low fee but can vary based on the size of the plan and the level of provider the employer can afford.
The 401k is the most popular of these type of workplace plans but there are others that function in the same way. A 403b plan is very similar but is used by people in the education and medical fields. A 457b plan is similar and is used by state and local government employees as well as some medical professionals.
Changes with SECURE Act
Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates:
· The cap on the percent an employee can contribute thru automatic annual increases from 10 to 15%
· Part time employees that have worked at least 1000 hours or 500 hours for at least three years are now eligible to participate in the plan.
· The previous age for beginning to take RMD from the account was 70 ½, it is now 72
That completes our overview of 401k plans. If you are one of the 100 million 401k account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD from your employer which will have all of the rules for your specific plan.
As always, if you have any questions regarding your personal finances please let us know at firstname.lastname@example.org. Look for the next blog post in the coming weeks on IRA plans.
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